If you are going to read one thing and just one thing on the financial crisis and how it is working itself out you need to read this blog post at naked capitalism: the one stop shop for understanding contemporary finance.

After the September 2008 crash, Iceland’s government took over the old, collapsed, banks and created new ones in their place. Original bondholders of the old banks off-loaded the Icelandic bank bonds in the market for pennies on the dollar. The buyers were vulture funds. These bondholders became the owners of the old banks, as all shareholders were wiped out. In October, the government’s monetary authority appointed new boards to control the banks. Three new banks were set up, and all the deposits, mortgages and other bank loans were transferred to these new, healthier banks – at a steep discount. These new banks received 80 percent of the assets, the old banks 20 percent.

Then, owners of the old banks were given control over two of the new banks (87% and 95% respectively). The owners of these new banks were called vultures not only because of the steep discount at which the financial assets and claims of the old banks were transferred, but mainly because they already had bought control of the old banks at pennies on the dollar.

The result is that instead of the government keeping the banks and simply wiping them out in bankruptcy, the government kept aside and let vulture investors reap a giant windfall – that now threatens to plunge Iceland’s economy into chronic financial austerity. In retrospect, none of this was necessary. The question is, what can the government do to clean up the mess that it has created by so gullibly taking bad IMF advice?

In the United States, banks receiving TARP bailout money were supposed to negotiate with mortgage debtors to write down the debts to market prices and/or the ability to pay. This was not done. Likewise in Iceland, the vulture funds that bought the bad “old bank” loans were supposed to pass on the debt write-downs to the debtors. This was not done either. In fact, the loan principals continued to be revalued upward in keeping with Iceland’s unique indexing designed to save banks from taking a loss – that is, to make sure that the economy as a whole suffers, even suffering a fatal austerity attack, so that bankers will be “made whole.” This means making a windfall fortune for the vultures who buy bad loans on the cheap.

The global economy is in the toilet and the Boomers’ representatives are chanting: “flush, flush, flush.” Me? I am eating cigarettes and wine while admiring the remarkable consistency in the myopia of all of it.

In the name of fiscal prudence the whole of the advanced capitalist zone is in engaged in austerity budgeting and calls for more of the same. Even Martin Wolf, in his otherwise insightful column in the FT online today, felt the need to tap his hat and nod in the direction of the genteelism of supply. Exhibit A, the conclusion to his incisive intervention:

Reconsidering fiscal policy is not all that is needed. Monetary policy still has an important role. So, too, do supply-side reforms, particularly changes in taxation that promote investment. So, not least, does global rebalancing. Yet now, in a world of excess saving, the last thing we need is for creditworthy governments to slash their borrowings.

As is widely acknowledged, monetary policy has little outside of conciliatory role to play at this time. In so far as the CBs should not make the mistake of tightening policy as the ECB and the BoC did. But apart from the role of spoiler there really is not much left for the CBs to do. The problem is squarely fiscal. As Wolf himself went to pains to argue. Why then the conclusion given that further tax reductions are not only going to make the fiscal positions of governments worse they will also likely have the same effect as lowering interest rates at this time: Nadda, ziltch, rien, nothing? The problem is that Wolf has to tip his hat to conventional wisdom. If not; he has no hope of bending the ears of policy makers. Oh well, that is his plight not mine.

Here, given none are listening we may speak frankly. The world economy is in the toilet because free trade, tax cuts, deregulation and above all the liberalization of finance over the last thirty years let loose a Tsunami of forces both economic and political. The liberalization of finance and production allowed for the national gutting and then global whipsawing of labour. As the profiteers profited and retired workers slept while the assets they had built were being systematically stripped and the fortunes being amassed were then turned to the seedy business (although a time honoured practice if one cares to actually read Smith) of buying off the government–and it must be stressed the intelligentsia too–broadly understood.

We now have the perfect storm. A generation of public and private sector functionaries has been trained to believe that the market can do no wrong and the government no good. As a corollary is of course the proposition that monetary and regressive tax policy is everything.

The irony, of course, is that any credible account of the present crisis would have to admit that we are here because free trade, tax cuts, deregulation, the flexibilization of labour markets and above all the liberalization of finance brought us here. How odd it is then that we should be treated to more of the same as the cure for what ails us.

Just go read Terence Corcoran’s latest in the National Post. Never mind that the world was plunged into economic crisis by unregulated financial institutions and near fully captured regulators; never mind that by most accounts the financial regulatory reform that has taken place since has been mild and the regulators are still, for the most part, in the hostage room. Terence tell us that one of the central reasons for the continuation of the slump is:

Banks are being regulated to an extent never seen before, forcing the world’s core providers of credit for business expansion to curb their appetite for risk. Confusion reigns as global and trans-national regulators blunder their way to impose ill-conceived rules and policies. The hard reality of new rules, ­especially new capital requirements, is that it forces banks to accumulate risk-free liabilities while curbing risk-taking loans.

For the right it is always the same villain: the government. During the crisis they blamed the government because…wait for it…they did not regulate properly and the crisis was therefore evidence of state not market failure. Now, as then, it is the state that is failing, not markets.

To wit, Terence finishes with:

Similar government interventions, bolstered by constant calls for more spending and taxes, are the norm through most of the G20 membership. To end the many debt crises, the first step should be to abandon growth-killing policies. With growth, even debts cease to be a problem.

Just where is Terence getting his information from? The G20 is busy doing austerity across the advanced capitalist zone and not in the form of tax increases. Does he even read his colleagues blogs?

This is something that should always be kept in mind in economic policy discussions: most economists are pro-Market, not pro-Public Interest.

It is especially important to keep this in mind when we read commentary such as this, in which an economist from one of Canada’s smaller economics departments conflates being pro-market with being in the public interest.

This point is sometimes hard to see, especially since many economists hold to the deeply ingrained syllogism that being pro-market is straightforwardly being in the public interest.

But they are a lobby group like any other, and cannot be relied upon to defend the general public interest.*

Economists, particularly academic economists (and like all academics), rely on, for their social status, research funding and a quiet concious, having the public view them as working in the public interest. And given the majority of economists are true believers in the “market” that inevitably gets conflated with being in the public interest

Cloaking oneself as being in the public interest is of course one of the oldest rhetorical stances to take since like wearing the national flag it clearly puts the speaker in the role of the hero and casts those being spoken against in the role of the villains. This is all the more easy to to do when the terms of conversation are being articulated in fuzzy, ill defined concepts such as the “public interest” and “pro-market”. When an economist uses those terms they have very exotic definitions in mind that most lay people would not readily grasp. Perhaps I am being too charitable: I can’t, in fact, find a definition of the public interest in any my economics text-books.

The public interest is a rather fuzzy notion. We can perhaps all agree that it has something to do with public goods but that just raises the thorny issue of what is and what is not a public good. In any case the argument at least has to be made that a specific policy is in the public good and why. Just standing around hands waiving in the air mindlessly chanting pro-market rhetoric like “free trade” or deregulation does not really cut the mustard.

Indeed after a generation of pro-market policies like financial liberalization and deregulation with cascading financial crises of increasingly damaging intensity culminating in the Great Financial Crisis that was 2007 and from which no advanced capitalist economy has yet to emerge; in which whole nations like Iceland, Greece and Ireland were raised; in which untold millions of workers were put and remain out of work; and as a consequence a massive hole was blown in public finances around the world, it should be clear that pro-market policies are not always or even in the majority of cases un-problematically in the public good to say the very least.

Notice that even if you are want to argue that it was bad government regulation in the US which caused the Great Financial Crisis the fact is that decades of financial liberalization and deregulation (pro-market policies) directly led to the formation of global investment and insurance markets which made sure that a “made in the USA” problem had serious global consequences. And it is not just that economists did not foresee these negative consequences they actually argued in favour of these policies on the grounds that such a crisis was less likely to occur and that the consequences would be less severe in the event that it did occur because these pro-market policies allowed risk to be more evenly spread. So much for theory.

That a pro-market economist is given a national soap-box on which to conflate being Pro-market with being in the Public Interest does not bode well for the Public Interest.

* The first four paragraphs are an inverted paraphrase of the linked commentary. I apologize to my readers for reproducing a very clichéd prose style.

For some I know this will seem a little too low on the list, but it is low because it really is low. When you are trapped inside GET (general equilibrium theory) reality is your enemy. Inside GET everything is tranquil–like a heroin addict after the needle is in and the payload delivered. In this exotic den of opium everything is tractable (well no really, Nash cooked this dream off like a poet in the night). Take a brave step away and not all that starts well ends well–and here we are not just talking about aggregation problems.

The efficient market hypothesis (EMH) not only claimed that financial markets were narrowly efficient as in they embodied all the relevant information and said information was conveyed in usably due time, but, also, that following Hayek such information was superior to any information that could be gathered and thus regulated by a central authority.

The outside play here was that ay attempt to regulate financial markets was doomed to failure because market participants would necessarily have at their disposal timely and thus superior information than public regulators. This argument got pushed so far that it was even argued that self regulation by private individuals would be superior as private actors would have better information. This logic of course suffered from a begging the question problem as in: if information is rapidly disseminated by market actors why can’t the state access that information and evolve policy and regulations in lock-step? That is to say, if information is efficiently conveyed why can’t regulators access and then use this information to regulate.

Two defences are available to the apostles of EMH. The first would argue that because the state is not a direct player in markets it in fact does not have access to this information. This is likely true, but the problem is that such a defence invites government participation in financial markets precisely so it can monitor and regulate the industry. YET, this conclusion is exactly the one EMH was designed to trounce. EMH was above all about the capacity of markets to auto-regulate. Why after all is the state needed when private markets are already efficient.

The second, and preferred, line of defence is then the argument that markets were efficient but the quality of the information was bad and that in time markets self corrected via what layman have come to call the Great Financial Crisis (GFC). Here the GFC is painted not as a crisis but an updating from poor information to good and is thus a confirmation of the EMF.

This second line of defence of course suffers from the obvious wrinkle that it boils down to the proposition that markets get things hopelessly wrong and that they can do so for such a prolonged period of time that the whole economy (not just finance) gets sucked into the vortex of ignorance. Presented as such the second line of defence is rather effervescent. For if the updating process takes such a long time and is capable of spreading bad information across a whole host of different markets from housing through to food and energy then the case for government regulation would seem strong.

But alas no! No because we only need to default back to defence one which is that the state does not have any better information than markets. But this only begs the question about the role of the state not just in terms of the regulator but in terms of a participant. In principle there is nothing that stops the state from becoming a significant player in financial markets: taking in information and then asking prudential third party questions.

In a nutshell those who would defend EMH via the second stratagem did so to avoid increased state involvement but then they have to defer to stratagem one in order to salvo the second. But stratagem one begs the question.

None of this is gainsaid by the obvious blooper that calling something efficient which demands that entire economies suffer the pain of “updating” is incredibly glib. Auto-regulation ought to imply smooth processes of adjustment. IF what EMH boils down to is that good information is turbulent which is eventually self-correcting after long period of pain then we really are back to the debates which raged before and after the Second World War.

My bet is this: Diamond and Fama will never win the Swedish bank prize but many economists will retain the ontological model in the back of their heads and demand no less from their graduate students.

A recently released research paper coming out of the IMF is worth your time. Particularly so if you find yourself making what you take to be a serious argument about the link between inequality and macroeconomic stability but can’t seem to get any respect. Over thirty years of neoliberalism it has been constantly argued that inequality was good for growth and economic stability; this IMF paper argues the opposite and has the neat feature that it is based in evidence rather than in elegant counter intuitive theory.

The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and eventual financial and real crisis.

The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But restoration of the lower income group’s bargaining power is more effective.

It is bad when the most pertinent of commentaries gets no response. What is ironic here is that at the micro level banks are telling their public stop pretending we are not extending even though they face near zero costs or in the case of the US negative costs.

You leave out an important scenario: in a zero interest rate environment, no bank is bad. This is why otherwise insolvent banks like Bank of America or Citi can stay solvent. It doesn’t matter the proportion of non-performing loans on the asset side as long as its cost of funds is minimal. Banks are thus engaged in a race with time to capture a positive return to recapitalize before interest rates rise.

Posted by: Guillaume | November 08, 2010 at 10:48 PM

Yep extend and pretend. That is the future but it is not as yet the present.

I wish I had the time to work through this more systematically but I do not. But can anyone watching the US senate grilling of G&S execs believe in the micro-foundations of orthodox economics (scientific liberalism)? What I liked was Sen. Levin’s interpretation of a Market Maker (MM) and G&S’s interpretation of MM. The G&S position is thus: we can sell anything to anybody without divulging what we think it is worth; in fact our obligation is to sell shit, if it is shit, it is just that shit, and we have no obligation to divulge our position about its quality.

This is simply buyer beware all trussed up. I am kind of sympathetic to this position as far as it applies to capitalism. The job of a capitalist enterprise is to make a profit: Some profit by selling quality and some profit by selling fake versions of Viagra. To paraphrase Marx: “capitalists seek profits; that in the process real or imagined needs get satisfied, satisfied well, or not is of secondary importance to the capitalist.” People sell lemons all the time in the attempt to lay-off their risk. In for the penny into the pound.

The community sets the standards on what is fraud and what is not. Now of course it is clear that firms like G&S bought the regulator (or in more polite form captured the regulator). So all of this is a bit of a smoke screen: political theatre. The real question is about how the state came to give these firms such latitude to determine what is fraud and what is not: or what is a lemon what is not?

Standard micro economic theory has a highly transparent view of information. Between the rational expectations and the implied substance of the efficient market hypothesis G&S should never have been able to push junk onto a market and find buyers in a sustained fashion over a prolonged period of time. But the G&S defence wants it both ways: we can sell shit because buyers should know they are buying shit. And they want to say we can sell shit because nothing obliges us to divulge the fact we are selling and saying shit.

And this is not much different from standard economic theory. Standard economic theory is want to say that shit can be sold because the market will almost instantly recognize that it is shit and that is the natural limit thus we do not need regulation to define shit. But G&S’s actions prove that market makers have an informational advantage that will not necessarily disappear by the discovery processes of market agents; at least not any meaningful sense of what is meant by this. The EMH boyz now want to redefine colossal market failure (the failure for good information to drive out bad) as the financial crisis. The crisis, the market pancaking thus becomes the rectifying process, the proof of real information discovery. That is like saying nautical engineers are successful because when ships sink they really sink.

What the sad story of G&S actually indicates is that market makers really make markets and that information is, by design, and in the absence of regulation, asymmetrical and consciously so. In a more revolutionary direction G&S, along with the entire private financial sector, indicates that private entities, if they have the financial wherewithal, will thwart, to the best of their abilities, the capacity for public oversight and regulation. This being the case it would seem to suggest that some activities ought to be brought under the public domain.

My American readers will not understand this post as it uses “liberal” in the the political theory/philosophical sense of the word. If they understood this they would realize they were all liberals and that was the reason they had a two party, single ideological system. But I digress. The point of this post is a workout of what I have come to term scientific liberalism. And it was inspired by a post by none other than a post by Mel Watkins over at the PEF.

At first I was quite struck by Nassim’s idea of Black Swans (indeed I threw a blog post up about it some good while back) but then when I started thinking about what he was saying it seem to me to amount to the fact that risk was not adequately priced in because the models being used on the street had effectively cut the last 5% of the left hand side of the distribution out from their models. His critique is reasonable enough. I think his story about about fat Vinny is compelling: the old wise man who has been around long enough to smell a bubble but whose warnings are ignored because the young bucks’ models only go back ten years and thus not only are rare events viewed as extremely rare they simply are not in the model . But I think the problem is deeper, much deeper.

Some critics have argued that liberal economists merely make the assumption of rational expectations because it makes the model tractable. That is, in absence of needing to solve the model liberal economists would not insist on rational expectations: it is just the necessity of precision.

I do not buy this argument and not because I think that the precision they have purchased is worthless with respect to reality (it bugs me but it is not a deal breaker). The problem I have is that at the ontological level (and let me coin a new term here) scientific liberalism, of which liberal economists are surely the van guard, are busy trying to prove that an economy in which property owners (not cars or houses but means by which society must reproduce itself) are free to do as they please with their property is not only a necessary condition of liberty but will on the whole lead to an ever increasing betterment of society in general.

Viewed from this angle, rational expectations is not merely a simplifying assumption necessary to make the model tractable it is necessary in the ideological sense of furthering the ideological project of liberalism. When a liberal economists demands: why do you not include me in the progressive camp? He (most probably) or she is not being disingenuous. In their mind they are the van guard of progress because they are busy via scientific liberalism of demonstrating the path to human betterment which is of course always defined as growth. Distribution of that growth or catastrophic failures of the system are just the price of the freedom dance.

Of course the high modernist cousin to scientific liberalism is scientific socialism: “just one more five year plan and we will get it right” said the commissar. There was a legitimacy to that position when the system was new, when there was no history; just a series of experiments where time would tell if they got it right. scientific liberalism cheats at this game: they want to prove the maximisation of happiness; and then when the gig is up they want to default to satisficing

So having removed the secondary and tertiary hydraulic back-up systems they proclaim the predetermined plane crash as a natural event when the original claim was that eliminating those systems would not jeopardize safety. It is fundamentally dishonest and a sad commentary on scientific liberalism that it can so effortlessly move from the best of all possible worlds to a necessary evil in the same breath. But unlike its cousin scientific socialism it (scientific liberalism) has yet to meet its Waterloo.

What an odd week. David Dodge wants an adult conversation about tax levels and the quality of public services. This clearly runs afoul of the conservative meme that less is always more. But the big show- stopper had to be Carney’s remarks on Canada’s abysmal productivity record. Carney bluntly argued that the business community had been showered for some time with a pro-business, pro growth policies but had failed to deliver the goods as it were. A Globe column by Kevin Carmichael and Iain Marlow nicely captured the essence of it:

Insulting or not, Mr. Carney’s comments represent a certain frustration among policy makers who feel they have done everything the business lobby says is necessary to encourage better productivity and innovation – only to see executives sit on piles of cash and avoid the risks taken by companies in countries where productivity is higher, such as the United States.

For example, Canada’s corporate tax rates are among the lowest in the world, thanks to a near-universal acceptance on the part of federal and provincial governments in recent years that this is necessary to spur investment.

Clearly the business community is miffed because someone, and not just an anybody but a somebody, finally asked the relevant question: After a GENERATION of giving corporate Canada public policy, hand delivered on a silver tray, where pray tell, for the love of all that is profane, are the results?

Over at the Post, no surprise, Terence Corcoran, attempts to exercise the intellectual side of his brain. Inter alia he dusts off Hegel in an attempt to preserve The World Historical Spirit; aka the right of private property owners to do what they want; aka, naked capitalism (this is Corcoran’s reading of Hegel).

As for productivity, even Mr. Carney’s review of the causes of Canada’s poor performance failed to come to any clear conclusions. Maybe it’s this, maybe it’s that, maybe it’s lack of competition, too many small firms, lags in investment results, to few high-tech innovators. Even in finance, supposedly Canada’s global trump card, Canada severely lagged the United States in productivity growth. And maybe nobody has a clue.

One thing is certain, no business makes investment decisions to achieve national productivity goals set by the Bank of Canada. Even Hegel got it. In Philosophy of Right, he wrote: “Wealth, like any other mass, makes itself into a power. Accumulation of wealth takes place partly by chance, partly through the universal mode of production and distribution. Wealth is a point of attraction.” The message, perhaps, being that central banks have nothing to do with it.

Productivity as divine mystery not even as divine revelation! What a glib Hegelian Corcoran is. And what an odd twist he throws on Hegel too. Increasing wealth for Hegel, as later with his student Marx, comes along with increasing poverty. Knowing this we can appropriately re-read Corcoran’s conclusion:

Wealth and poverty are something the central bank has nothing to do with.

Self serving, de-politicizing, obfuscating clap trap.

What seems to have Corcoran so exercised is that Carney made a big mistake: he pointed out that business has not delivered productivity. That is, he politicized the issue. What Corcoran and the other ciphers of private privilege do not get is that sooner or later public officials and institutions have to provide outcomes that preserve and increase the general good. Neoliberals like Corcoran error when they think they cling to to the meme that private gain always translates into public betterment and will never be asked to pony-up. It is as if he, Corcoran, is angry that Carney betrayed the IgNobel Truth: increases in private privilege are accompanied, more often than not, by increases in private deprivation.